Work product protection and attorney-client privilege in an IRS audit

In Veolia Environnement North America Operations Inc., a
U.S. district court reviewed the scope of the work product rule and
the attorney-client privilege in the context of an IRS audit.

The dispute arose out of an IRS audit of a $4.5 billion deduction for
worthless stock claimed by Veolia Environnement North America
Operations Inc. on its 2006 federal income tax return. Veolia had
purchased a subsidiary corporation in 1999 and concluded that the
stock in the subsidiary was worthless. It retained legal counsel and
other experts to devise and implement a strategy by which it could
claim a deduction for the worthless stock under Sec. 165(g). As
part of its evaluation, Veolia and its legal counsel hired two
valuation firms to examine the insolvency of the subsidiary. After
consulting with its legal counsel and experts and obtaining a private
letter ruling (IRS
Letter Ruling 200710004), Veolia converted its subsidiary
corporation into a limited liability company to claim the $4.5 billion
worthless stock deduction on its 2006 tax return.

Anticipating an audit, Veolia enrolled in the IRS’s Pre-Filing
Agreement (PFA) program and provided the IRS written reports from its
insolvency experts as support for its claim that the subsidiary’s
stock was worthless. The IRS issued summonses for a variety of
documents in Veolia’s possession relating to the worthless stock
deduction and the underlying transaction. Veolia delivered thousands
of pages of documents in response to the summonses but withheld
certain documents, claiming that the documents were privileged under
(1) work product protection under Federal Rules of Civil Procedure Rule
26(b)(3); (2) the attorney-client privilege; and/or (3) the tax
practitioner privilege under Sec. 7525(a)(1). The IRS filed a
motion to enforce the summonses and compel the production of the
withheld documents.

Under the work product rule, a party to federal litigation “may not
discover documents … that are prepared in anticipation of litigation
or for trial by or for another party or its representative” (Fed. R.
Civ. P. 26(b)(3)(A)). Such protection, however, is limited to
documents actually prepared in anticipation of litigation and does not
apply to materials prepared “in the ordinary course of business.”
Further, the party seeking work product protection must demonstrate
that it subjectively intended for the work product to be used
in litigation and that the anticipation of litigation was
objectively reasonable.

The IRS questioned whether the documents for which Veolia sought work
product protection were prepared in anticipation of litigation or in
the taxpayer’s ordinary course of business, since its business
activities included acquiring, managing, and divesting operating
subsidiary companies. The court held that Veolia met its burden of
proving that it anticipated litigation before preparing the documents
in question. The taxpayer obtained valuation reports, sought a private
letter ruling, and participated in the PFA program because of the
prospect of litigation with the IRS. The court concluded that Veolia’s
expectation of litigation was objectively reasonable, given the size
of the deduction and the fact that the taxpayer was already under
audit for prior years. Importantly, the court also concluded that the
fact that the taxpayer undertook such transactions in the ordinary
course of its business “does not deprive the Taxpayer of the
opportunity to meet its burden to show that it anticipated litigation
would arise from these particular transactions.” There was no evidence
that the transaction under review was undertaken for any purpose other
than to recognize a $4.5 billion loss on its tax return and litigate
with the IRS over its deductibility.

The court also addressed whether certain materials furnished to the
valuation experts to assist in their preparation of appraisal reports
must be disclosed by the taxpayer to the IRS. At issue were documents
containing communications of fact or data provided to the valuation
experts by persons or entities other than Veolia’s legal counsel. The
court concluded that Rule 26(b)(4)(C) protects communications only
between a party’s attorney and its testifying expert but that data
provided to the expert by sources other than the party’s attorney are
not protected by the rule and must be disclosed. The court ordered
Veolia to produce any materials containing facts or data considered by
the valuation experts in forming their opinions “even if such facts or
data were provided by [another third-party expert] or anyone else or
any entity other than the Taxpayer and Taxpayer’s attorneys.”

Although the court made no specific ruling on the production of any
of the disputed documents based on the taxpayer’s assertion of the
attorney-client privilege, the court did note that the proper
assertion of this privilege must include a showing that the
communication in question was made for the purpose of obtaining or
providing legal assistance. Nonlegal business advice offered by
attorneys is not covered by either the attorney-client privilege or
the tax practitioner-client privilege. Under Sec. 7525(a)(1),
communications between a taxpayer and a federally authorized tax
practitioner for the purpose of obtaining tax advice generally are
accorded the same protection in noncriminal proceedings as
communications between a taxpayer and an attorney, to the extent that
they would be privileged communications between the taxpayer and the
attorney.

Finally, the court briefly addressed whether the attorney-client
privilege is waived when the withheld materials are widely distributed
among individuals who work for the taxpayer or entities related to the
taxpayer. The court concluded that the taxpayer had common interests
with the related entities with which it shared the communications and
that sharing the communications with individuals employed by these
entities was necessary to obtain or act upon the legal or tax advice
sought by the taxpayer. Thus, the court found no waiver of the
privilege had occurred.

By Gary Sanders, J.D., clinical instructor of
business law and accounting, and Darlene Pulliam, CPA,
Ph.D., Regents Professor and McCray Professor of
Accounting, both of the College of Business, West Texas A&M
University, Canyon, Texas.